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Cover Story: Bitter medicine

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The case for global regulation of the banking and finance industry has become much stronger as a result of the recent crisis. The prospect of creating a workable system, though, is as remote as ever.

It’s official: The freewheeling, Wild West world of a lightly regulated global financial system has come to an abrupt end. As terrified bankers watching their empires collapse ran cap-in-hand to equally panicked governments, the stage was set for a radical overhaul of not just the world’s entire financial system but also the regulatory structure under which it operates. Under the existing patchwork of rules, the global banking industry had become so dangerously intertwined and startlingly opaque that it drove the international financial system to the brink of a systemic collapse that was prevented only by the concerted efforts of—and mind-bogglingly large injections of capital from—the governments of the world’s largest economies.

The price of the bailout will be high. While governments help themselves to huge stakes in many of the world’s biggest banks, the hand of the regulator is set to move into the global banking system with a firmness and invasiveness that will set every banker trembling. A banking system that had enjoyed the light touch of the regulator for so long is facing a very different prospect. Adair Turner, the head of Britain’s Financial Services Authority (FSA), warned that Britain’s banks face a hard-line regime of supervision. He said the regulator had been guilty of supervising them “on the cheap” and added: “There is no doubt the touch will be heavier. We have to make sure it is intelligent and focused on where the risks really are.”

Governments’ goal in giving regulators new authority will be the creation of bullet-proof structures—banks that will not put at risk the billions of dollars of state money now being invested in banks around the world. But in a comment that will send chills down the spine of any banker accepting a state bailout, Peter Hahn, an academic at the London Business School, says, “We are regulating institutions that are so big that it is inconceivable that they can fail, so we want them to be horribly overregulated, boring, boring places.”

Hahn believes the tightened regulatory oversight will create a drag on the global economy by adding expense for financial institutions, creating lower yields on deposits, higher costs on loans and higher prices for services. He also says it will further polarize the banking industry: “We will end up with giants and sardines. There will be little guys around. They will present opportunities, but they will need levels of support, things like deposit insurance. They will become the risk-takers and innovators. We will see smaller investment banks which are mostly equity funded.”

John Kay, the founder and managing director of economic and policy consultant London Economics, is anxious about the implications for the banking system, pointing out that commercial and investment banks have different, indeed mutually incompatible, cultures. He is skeptical about allowing the two types of institutions to be bonded at the hip. “The utility is attached to the casino,” he says. “The utility is the payment system for the non-financial sector. It serves as a safe place for deposits of modest size and enables small and medium-size companies and individuals to engage in a realistic level of personal borrowing. The casino engages in the dizzying complexities involved in securitization. This requires an interbank market that is many times larger than is economically necessary. A great deal of money has been made and now lost on the casino side of the operation. The losses of the casino have nothing to do with the utility side of the operation.”

While some might argue that investment banks are too risky a concept to be tolerated in the financial system in any guise, Kay argues for a structure that admits them, with a heavy health warning. “I wouldn’t want to prohibit other forms of trading in money and short-term instruments, but I don’t want to regulate and I do want to protect the utility from it. It can’t be allowed to jeopardize the utility.”

Kay believes that one cause of the current crisis is that banks have been allowed to use implicitly government-guaranteed retail deposits as collateral for speculative trading. “This is what they’ve done, and this has made the scale of that operation possible and now in effect destroyed three of the five independent investment banks that don’t have that base to call on,” he adds.

The financial system needs comprehensive and uniform levels of regulation, says Martin Wolf, a columnist for The Financial Times. Wolf told Global Finance, “The parts of the financial system are of such vast social significance and affect each other so directly that they must be very heavily regulated in what they do. They can’t be treated as separate independent businesses. They all get into trouble together. The solution is a much more highly regulated core financial system, and that includes activities that used to be in investment banks and derivatives markets.”

Wolf agrees with Kay that the risk-taking and deposit-handling aspects of banking have become dangerously commingled. “We have allowed banks to provide both an essential utility function on which the entire economic system depends and at the same time gamble freely and at will with next to no capital behind it, essentially at the taxpayers’ expense. That is not tolerable,” he asserts.

Today’s turmoil has dramatically changed both the climate of regulation and its scope, says Stephen Lewis, the chief economist at Monument Securities. In some ways the shakeout has created a system that will more easily accommodate global oversight. “There will be a diminution in the number of institutions to be regulated and a decline in the number of viable products. That will make it easier for bank supervisors to step in and regulate. We may not have globalized financial markets in the way we have got used to,” he adds.

The regulators now taking control in London, on Wall Street and beyond are demanding greater reach and more power to scrutinize their charges. They will bid to determine the size of bonuses, the competence and qualifications of management and management strategy. What is left of management autonomy after the current cull will be highly circumscribed by regulators armed with new banking laws and a public mandate to rein in the managers. Bankers’ capacity to determine the look of a new and sustainable banking system will be curbed by virtue of their inability to manage yesterday’s system.

Governments and banks will also reassess the entire structure of the banking system, its risk base and its management quality and standards. In the short term, says George Magnus, a senior adviser at UBS, governments will get more involved in the structure of banks and their culture, but their influence will reduce as stability returns. “Government intervention is a political as well as economic and financial issue. In the medium to long run the greater activism of the state in the financial system will fade, much as it did in the decades after the 1930s and again after the 1980s,” he says.

Global Banks Need Global Rules

The drive toward a more global system of regulation should hardly come as a shock to an industry that has spent the past decade breaking down barriers between countries and markets. Willem Buiter, a former member of the Monetary Policy Committee of the Bank of England, says regulators will need global reach over a financial market that is globalized. “We have to completely rethink regulation,” he explains. “When the financial system, at least the highly leveraged part of it, is collapsing around our ears, it is clear that something has gone wrong,” he adds. “The jurisdiction and geography of regulation has to be the same as the domain of the market. You should get as close as possible to regulating on a global level. You would need a contact with the global regulator in each market segment, at least in the border-crossing businesses. We need to act at the most international level possible.”

Underlying the calls for global regulations is a widespread disenchantment among the global financial community with today’s regulatory bodies. Participants and observers are seeking to devise new institutions to replaced failed bodies. Jeffrey Garten, a professor at the Yale School of Management, advocates the creation of a global monetary authority to oversee the international capital markets. “The International Monetary Fund is irrelevant to this crisis, the Group of Seven leading industrial countries lacks legitimacy in a world where China, Brazil and others are big players, and the Bank for International Settlements has no operational role. The US Federal Reserve is too besieged to act as a global central bank,” he asserts.

Tim Congdon, a noted British monetarist, joins the chorus of dissent with the global regulatory regime: “The Basel rules have failed. The notion that these rules would sort out the banking system has failed. International regulation has failed,” he says.

Devising a workable global regulatory system is tremendously challenging, though. One facet of current regulatory institutions that attracts severe criticism is the level of bureaucracy in institutions that claim to be able to oversee every part of a financial community. Amorphous institutions such as the UK’s FSA, for example, will no longer suffice to keep a watch on the inner workings of the banks, says Congdon. “You won’t get all these national systems under one uniform set of regulations. Insurance, banking, securities are different businesses, and they should have different regulators,” he says.

Congdon advocates breaking the regulatory role down to reflect the different functions of the markets. “There should be three types of financial regulation with three separate bodies,” he says. Taking the United Kingdom as an example, he adds: “The Bank of England is the regulator of the banking system. It should watch both liquidity and solvency of the banking system and make sure that there are never crises of this sort because it is close to the banks and it lends to them in all sorts of discreet and quiet ways. At the moment, the Bank of England has become no more than an economic research department.”

Monument Securities’ Lewis also believes that current regulatory models have let down the banking system. “Bank regulation is a very special skill, and there is not much sense in housing it within an overarching institution,” he says. “You either have a separate bank supervisory agency, or you let the central bank do it. You certainly don’t house it in the same building that handles the mis-selling of insurance policies. There is no logic whatsoever in that.”

Lack of communication between central banks and regulators has undermined the regulatory system, says the London Business School’s Hahn, adding that the recognition of that fact during the current crisis will give an impetus for a new push for global regulation. “There has been an amazing lack of coordination and duplication. Massive gaps in international regulation have been exposed,” he says.

Despite the clear need, though, Hahn is pessimistic about the prospects for truly effective global regulations. “We have been moving toward a global regime forever, but we don’t have the institutions to do that,” he says. Buiter is no more optimistic. “You won’t get a global agency to oversee the entire financial system. There will be bodies like the Financial Stability Forum that may set guidelines for regulation and end up having the same weight as the Bank for International Settlements or the Basel requirements,” he says. “Even in the EU, there is a framework for a Europe-wide regulator, yet everybody runs for national cover at the first sign of headwinds. The odds of getting a global regulator, rather than a global body like the FSF or the BIS, are low.”

Dominique Strauss-Kahn, managing director of the International Monetary Fund, expects the IMF's role in the post-crisis world to expand significantly.

Lewis pins some of the blame for the current crisis on the quality of regulatory staff—partly because regulators cannot attract the highest caliber of staff, as they are unable to match the pay scales of the businesses they regulate. He does believe, however, that the recent shakeout will see new talent becoming available to the regulators. “Quite a lot of top-caliber people are floating around at the moment, although they may have to take lower salaries,” he says. “It is not good enough for them to throw up their hands and say we are not paid enough to evaluate these black box models so we will leave it up to you. Bank regulation is a very special skill, and it needs to be done by specialists.”

Buiter believes it is time for a fundamental reassessment of the regulators’ remit, focused on the levels of leverage and banks’ use of their balance sheets. “There should be regulation of all highly leveraged institutions. Whatever is deemed sufficiently large to be the subject of bailouts should be regulated in the same way, regardless of ownership structure. It is immaterial if they are privately owned and unlisted; if they are sufficiently large, they will be treated the same way. They will be regulated through limits on their leverage.”

Leverage and mismatch of assets and liabilities, especially maturity and currency mismatch, is at the root of financial booms and financial crunches, Buiter says. “It doesn’t matter whether the over-leveraged entity is technically an insurance company or it is an electrical or manufacturing company. The key thing is to regulate uniformly across the board, so there is no incentive to create off-balance-sheet vehicles. They will all be regulated as far as capital requirements, liquidity requirements, leverage ceilings, reporting requirements, even governance requirements.”

As the dust settles from the financial crisis, observers are anxious that the glaring need for a completely revised global regulatory system is not lost in complacency or throttled by red tape. Scrutiny of bank practices needs to go much further than merely adding to compliance departments and box-ticking, urges Kay. “I am concerned that when people talk about more regulation, they mean more form-filling. That could be entrusted to a compliance department, while everybody else gets on with what they’ve always been doing,” he says.

Kay and many other commentators are arguing for a rethink of the entire structure of banking, in light of weaknesses exposed by the credit crisis. New structures should be devised to insulate commercial banks from contagion by risks from investment banks. Kay argues for some form of legislation, mirroring, but not identical to, the Glass-Steagall Act of 1933, the former US legislation that required the separation of general and investment banking. That legislation had an extended life before banks challenged it to the point where it became unenforceable.

Regulators planning new structures to prevent a repeat of today’s fiasco have to work within a continuously changing picture. Lewis emphasizes the regulators’ changing remit. “We don’t know what instruments and markets will survive the period of turmoil. Will there be credit default swaps in the future? Will there be an interbank market? It is not unthinkable that there should not be. That will dictate the regulation system,” he comments.

However the system looks, though, one outcome is inevitable: The regulators and their governmental masters will have the influence and authority to enforce change on a level that the financial system has not seen for 70 years or more. The cultural and business impact on the banking system can scarcely be imagined.